Traditional Banking
11 important questions on Traditional Banking
What drives the change in the banks equity value when market yields change?
- The size of the shock
- The amount of leverage the bank uses
- The mismatch between the duration of the bank's assets and liabilities
How does a bank alter the durations of its assets and liabilities?
- On-balance sheet: issue new types of loans and/or liabilities, change capital structure
- Off-balance sheet: repurchase agreements, futures, options, swaps
Define liquidity risk to a bank and a borrower:
- Bank: risk that depositors may unexpectedly withdraw their deposits and the bank may be unable to replace them without impairing its net worth
- Borrower: risk that the lender may choose not to renew loan that the borrower wants to have renew
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What are the key sources of liquidity problems?
How has the composition of a commercial bank loan changed?
What is the definition of lending? and how do banks produce loans?
- Spot market purchases
- originate loans and then fund them by keeping them on their own books
- Purchase loans originated by other intermediaries
- forward market purchases
- loan commitment: a promise to lend in the future on pre-specified terms.
Why are loans and securities quite similar nowadays?
Today, loan sales, securitisation and loan syndication have created a secondary market for loans, increasing their liquidity. Thus the distinction became fuzzier
Decompose the lending function into 5 parts:
- Origination (application, credit analysis, loan design)
- Funding (loan extension)
- Servicing (Bookkeeping, collection payments)
- Risk processing (monitoring, diversification)
- Credit culture (organisational design, reporting, communication)
How is a loan agreement structured?
- Specifies the obligations of borrower and lender
- Makes certain warranties
- Places controls and restrictions on the borrower
Details:
- Principal
- maturity
- Pricing formula (fixed/floating, fee, ect.)
- Provisions (warranties, covenants, ect)
Explain credit rationing. Why is credit rationing a puzzling practice?
- there is unsatisfied demand for credit at the price posted by the bank
- It seems irrational for profit-maxizing banks to ration credit
What are the remedies against credit rationing?
- Screening / Credit analyses
- Monitoring
- Dynamics: Long term relationships help solve the asymmetric information problem. Reputation: When a borrower knows it needs to borrow in the future may limit actions. Relationship lending. The bank learns about the borrower quality in time. Information sharing: Lenders can improve information about borrower through information sharing (Trough credit bureaus who collect info)
- Contract design:
- Collarteral: allows to mitigate both problems
- Capital: positive down-payment by the entrepreneur (inside equity) as a condition to provide credit
- Staged funding: credit provided at different points in time, depending on the performance of the project.
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